Peripheral Eurozone bonds turned sour while the euro recovered since late last year. Which one tells the truth about the Eurozone's fate? Surprise, surprise; both of them do. In fact, the euro (NYSEARCA:FXE) might be telling an even more bearish story than Eurozone government bonds do. All three underlying forces of the single currency, i.e. trade and income flows, interest rate differences, and investors' sentiment, imply that the euro has been beaten too much. This means that it is not the euro which needs to be revalued significantly lower to reflect the European risks. On the contrary, the euro could even rebound further amidst the political turmoil of upcoming elections. Peripheral bonds, though, might get more pain in anticipation of less accommodative ECB policy.
Is Euro Oversold?
Euro is quite oversold if examined under any major viewpoint; trade and income flows, interest rate differentials between the Eurozone and other economies, and trader's sentiment.
From a trade viewpoint, the Eurozone (NYSEARCA:EZU) experiences its best net inflows ever. Eurozone's trade surplus, i.e. the positive gap between export revenues and import payments, has been climbing to new all-time highs in the last few years. The average monthly trade surplus, currently, is many times greater than what it was during the 2010-2012 Eurozone debt crisis. As a matter of fact, the trade balance was fluctuating above and below zero before starting to trend higher around early 2012. The exact same pattern held for the current account (CA), i.e. the difference between revenues from exports, and incomes from abroad and payments for imports, incomes to foreigners. This means that much more money flows into the euro system today than going out, as a result of ordinary economic activity. These CA surpluses turned the Eurozone from a net debtor to one of the biggest creditors globally. As a result, its net international investment position, i.e. the difference between assets held abroad and liabilities to foreigners, ballooned.
It is no surprise that Eurozone's surpluses have skyrocketed. The euro broad Trade Weighted Index (TWI), i.e. a gauge of the price of euro against 61 currencies weighted according to bi-lateral trade activity, is trending down in the last nine years. Still, the TWI in real terms, i.e. taking into account price differences between countries, has plummeted close to its lowest historical level. Such a cheap currency could not but producing sizeable surpluses, especially in an open economy such as the Eurozone.
Source: BIS, ieconomics.com
Beyond the historically high surpluses, euro is undergoing another major shift. A series of overheating indications in its core economies, namely an extremely tight jobs market, surprising positive manufacturing PMIs and exports, and inflation surprises, inflict pressure to the ECB to reverse course. The widening gap between Fed's tightening policy and ECB's loosening policy is expected to reverse. These expectations have already turned the direction of the gap between 10-year US and German yields down in the last few weeks. Should this difference shrink further, more money will exit the US and flock to euro-denominated bonds again, supporting the currency. From a monetary perspective, though, the euro could easily be pushed higher. If seen over a longer-term perspective, this difference in yields hovers around multi-year highs. In other words, market expectations are still tilted towards much tighter US than euro-area monetary conditions. These expectations are too bearish for the euro from a historical perspective.
A third driving factor of the euro is investors' sentiment. Again here, it can be shown that traders are still overly bearish against the euro. The CFTC euro net speculative positions, a gauge of the total number of bets on EURUSD through futures contracts, hover around -50K. This means that approximately 50K more bearish than bullish euro bets are placed in the market currently. This figure is about half the average size of net short positions witnessed during the peak of the Eurozone debt crisis in 2012. Yet, it is a sizeable bearish position in and of itself. It definitely indicates the steady belief of speculators in euro's demise.
An alternative indicator to gauge investor's sentiment is the implied volatility on the EURUSD rate. This is what the options market predicts the future volatility of the exchange rate will be and is provided by the CBOE Eurocurrency Volatility Index (EVZ). While EVZ trades around its average level of the last year or so, it is very elevated with respect to the historical volatility of EURUSD. This means that options traders fear that EURUSD volatility of the next 30 days will increase significantly in relation to what it was in the last 30 days. Implied volatility is about 3% higher than historical volatility, a level which cannot be sustained for long without reverting to its zero mean. Irrespective of the way this mean reversion will materialize, EVZ currently exhibits an excessively bearish sentiment towards euro.
Eurobonds Not Bearish Enough
While the euro market seems extremely pessimistic with respect to its underlying forces, the European bond market is barely so, despite its recent nervousness. The spreads between peripheral bonds and German bunds are picking up in the last few weeks. Still, they are far too low with respect to where they were trading during the Eurozone debt crisis, five years ago.
The difference between the Italian and German 10-year yields is headed towards 200 basis points from as low as 90 basis points a year ago. Still, this is much lower than the 400+ basis points experienced back in 2012. The Spanish 10-year spread is even more benign resting below 140 basis points. During the 2012 crisis, it was trading above 500 basis points. The recent 20 basis points pick-up in Spanish bond spreads is almost plain noise, within the typical trading range of the last two years or so. With the exception of Greece, the other peripheral bonds are yet to experience any significant spikes too. Only French 10-year yields have risen enough to push the spread back to its late 2012 level.
Overall, and despite the French and Greek outliers, European government bond spreads are nowhere near the egregious levels of the past. The euro, on the other hand, trades at excessively low levels with respect to its macro fundamentals, which are overwhelmingly improved since the sovereign debt crisis. Instead of the European bond market, it is the euro which seems to have received the biggest hits lately. If it wasn't for the excessive negative sentiment, the underlying net inflows to the euro should have already established a strong uptrend.
That said, it is not the euro which is positively decoupled from the other European assets. Rather the opposite. From the looks of it, the euro is held down by excessive fear while most European sovereign bonds are still trading at extremely complacent valuations. As soon as markets realize that the ECB will be forced to tighten the reins again, the euro will face a positive shift in demand and European sovereign bonds will get hit.
To take it differently, the longer the euro stays around here, the more surpluses Eurozone will be accumulating, let alone if it drops lower. These surpluses will bring more inflows inflicting an ever stronger upward pressure to the euro. Unless the Eurozone immediately falls apart, the bearish sentiment on the euro will at some point be insufficient to counteract the positive trade and investment flows. Then the big short squeeze will begin. This shows clearly that the euro already tells an even more bearish story for Eurozone than warranted.
The mystery about which market tells the true Eurozone story is unveiled. European bond investors should look elsewhere than the foreign exchange market to locate underpriced risks. They should, in fact, look at the optimistic valuations of peripheral bonds. The euro had enough troubles.
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